Baseline Scenario

Two views of the global financial crisis:

The Baseline Scenario
What Next For The Global Crisis?
Posted: 22 Jun 2009 08:14 PM PDT
Slides for speech to World Bank conference (Lessons from East Asia and the Global Financial Crisis), Tuesday in Seoul (1pm local time), are attached. This post summarizes my main points.
There are two views of the global financial crisis and – more importantly – of what comes next. The first is shared by almost all officials and underpins government thinking in the United States, the remainder of the G7, Western Europe, and beyond. The second is quite unofficial – no government official has yet been found anywhere near this position. Yet versions of this unofficial view have a great deal of support and may even be gaining traction over time as events unfold.
The official view is that a rare and unfortunate accident occurred in the fall of 2008. The heart of the world’s financial system, in and around the United States, suddenly became unstable. Presumably this instability had a cause – and most official statements begin with “the crisis had many causes” – but this is less important than the need for immediate and overwhelming macroeconomic policy action.
The official strategy, for example as stated clearly by Larry Summers is to support the banking system with all the financial means at the disposal of the official sector. This includes large amounts of cash, courtesy of Federal Reserve credits; repeated attempts to remove “bad assets” in some form or other, and – the apparent masterstroke – regulatory forbearance, as signaled through the recent stress tests.
But most important, it includes a massive fiscal stimulus implying, when all is said and done, that debt/GDP in the United States will roughly double (from 41% of GDP initially, up towards 80% of GDP).
Not surprisingly, funneling unlimited and essentially unconditional resources into the financial sector has buoyed confidence in both that sector and at least temporarily helped shore up confidence in financial markets more broadly.
And now, in striking contrast to the dramatic action they call for on the macroeconomic/bailout front, the official consensus claims relatively small adjustments to our regulatory system will be enough to close the case – and presumably prevent further recurrence of problems on this scale. If the exact causes and presumed redress are lost in mind-numbingly long list of adjustments, so much the better.
This is, after all, a crisis of experts – they deregulated, they ran risk management at major financial firms, they opined at board meetings – and now they have fixed it.
Maybe.
The second view, of course, is rather more skeptical regarding whether we are really out of crisis in any meaningful sense. In this view, the underlying cause of the crisis is much simpler – the economic supersizing of finance in the United States and elsewhere, as manifest particularly in the rise of big banks to positions of extraordinary political and cultural power.
If the size, nature, and clout of finance is the problem, then the official view is nothing close to a solution. At best, pumping resources into the financial sector delays the day of reckoning and likely increases its costs. More likely, the Mother of All Bailouts is storing up serious problems for the near-term future.
We’ll double our national debt (as a percent of GDP), and for what? To further entrench a rent-seeking set of firms that the government determined are “too big to fail,” but will not now take any steps to break up or otherwise limit their size.
We need to disengage from a financial sector that has become unsustainably large (see slides before and after #19; the cross-country data should be handled with care).
We can do this in various ways; there is no need to be dogmatic about any potential approach – if it works politically, do it. But the various current proposals for dealing with this issue – both from the administration and the leading committees of Congress – would make essentially zero progress.
As moving in this direction does not seem imminent, the probable consequences or – if you prefer – collateral damage looks horrible. You can see it as higher taxes in the future, lower growth, a bigger drag on our innovative capacity, fewer startups, and less genuinely productive entrepreneurship. Plenty of people will be hurt, and they are starting to figure this out – and to think harder about what needs to be done and by whom.
“Small enough to fail” may well prevail eventually – at least sensible ideas have won through in past US episodes – but it will take a while. The official consensus always seems immutable, right up until the moment it changes completely and forever.
By Simon Johnson